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CAPITAL STRUCTURE According to

Gerestenbeg Capital structure of
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CAPITAL STRUCTURE According to Gerestenbeg, “Capital structure of a company

refers to the composition or make-up of its capitalisation and it includes all long-term
capital resources viz : loans, reserves, shares and books. ” The capital structure is
made up of debt and equity securities and refers to permanent financing of a firm. It is
composed of long-term debt, preference share capital and shareholder’s funds.

FORMS/PATTERNS OF CAPITAL STRUCTURE Equity Shares only Equity Shares,

Preferences Shares and Debentures A new company consists of: Equity Shares and
Debentures Equity and Preferenc es shares

IMPORTANCE OF CAPITAL STRUCTURE The term capital structure refers to the

relationship between the various long-term forms of financing such as debentures,
preference share capital & equity share capital. The use of longterm fixed interest
bearing debt & preference share capital along with equity shares is called financial
leverage or trading on equity. This debt is employed by a firm to earn more from the
use of these sources then their cost so as to increase the return on owners equity.
FINANCIAL BREAK-EVEN POINT Financial break even point may be defined as that
level of EBIT which is just equal to pay the total financial charges, i. e. interest and
preference dividend. At this point EBIT = 0. If EBIT< financial break even point, the
EPS shall be –ve. If EBIT exceeds the financial break even point, more of such fixed
cost funds may be inducted in the capital structure. The financial break even point can
be calculated as:

(a) When the capital structure consists of equity share capital and debt only no
preference share capital is employed: Financial Break Even Point = Fixed Interest
Charges (b) When capital structure consists of equity share capital, preference share
capital and debt: Financial Break Even Point = I+ Dp (1 -t) Where, I= Fixed Interest
Charges Dp= Preference Dividend t= Tax Rate

POINT OF INDIFFERENCE AND UNCOMMITED EARNINGS PER SHARE Point of

indifference refers to that EBIT level at which earnings per share(EPS) remains the
same irrespective of different alternatives of debt-equity mix. However, sinking fund
appropriations for redemption of debt decrease the amount of earnings available for
equity shareholders.

The equivalency point for uncommitted earnings per share can be calculated as below:
(X-I) (1 -T)- PD- SF = (X-I) (1 -T)- PD- SF Where, X= Equivalency point or point of
indifference or break even EBIT level. I= Interest under alternative financial plan 1. I=
Interest under alternative financial plan 2. T= Tax rate. PD= Preference dividend. SF=
Sinking fund obligations. S= Number of equity shares or amount of share capital under
plan 1. S== Number of equity shares or amount of share capital under plan 2.
OPTIMAL CAPITAL STRUCTURE The capital structure is said to be an optimal capital
structure when a company selects such a mix of debt and equity which: (a) Minimises
the overall cost of capital; (b) Maximises the earning per share(EPS); (c) Maximises
the value of company; (d) Maximises the market value of the company’s equity shares;
(e) Maximises the wealth of the shareholders.

RISK- RETURN TRADE OFF The financial or capital structure decision of a firm to use
a certain proportion of debt or otherwise in the capital mix involves two types of risk:
(a) Financial Risk: (b) Non-Employment of Debt Capital (NEDC) Risk:

1. Financial Risk: The financial risk arises on account of the use of debt or fixed
interest bearing securities in its capital. A company with no debt financing has no
financial risk. The extent of financial risk depends on the leverage of the firms capital
structure. 2. Non-employment of Debt Capital(NEDC) Risk: The NEDC risk has an
inverse relationship with the ratio of debt in its total capital. Higher the debt-equity ratio
or the leverage, lower is the NEDC risk and vice versa.
CAPITAL STRUCTURE DECISIONS DEBT-EQUTY MIX FINANCIAL RISK NON-
EMPLOYMENT OF DEBT CAPITAL(NEDC) RISK-RETURN TRADE OFF MARKET-
VALUE OF TE FIRM (RISK-RETURN TRADE OFF)

THEORIES OF CAPITAL STRUCTURE The main contributors to theories are Durand,

Ezra, Solomon, Modigliani and Miller. The important theories are: 1. Net Income
Approach. 2. Net Operating Income Approach. 3. The Traditional Approach. 4.
Modigliani and Miller Approach.

1. Net Income Approach: This approach has been developed by Durand. The main
findings are: Ø Capital structure decisions are relevant to the valuation of the firm:
According to Net Income Approach, if a firm makes any change in its capital structure,
it will cause a corresponding change in the overall cost of capital as well as the total
value of the firm. Thus, the capital structure decisions are relevant to the valuation of
the firm.

Ø Increased use of debt will increase the shareholders’ earning: According to this
approach a firm can increase its total value(V) and lower the overall cost of capital
(Ko) by increasing the proportion of debt in its capital structure. In other words, the
increased use of debt will cause increase in the value of the firm as well as in the
earnings of the shareholders. As a result, the market value of equity shares of the
company will also increase.
ASSUMPTIONS (a) Capital structure consists of debt and equity. (b) Cost of debt is
less than cost of equity (i. e. Kd<Ke). (c) Cost of debt remains constant for all levels of
debt to equity. (d) The use of debt content does not change the risk perception of
investors.

CALCULATION OF THE VALUE OF THE FIRM According to Net Income Approach

the value of the firm can be ascertained as follows: V = S+ D where, V= Value of the
firm S= Market value of equity=Earnings available for equity shareholders/ Equity
capitalisation rate. D= Market value of debt.

CALCULATION OF OVERALL COST OF CAPITAL According to Net Income

Approach the overall cost of capital can be calculated as follows: (Ko) = EBIT X 100 v
where, (Ko)= Overall cost of capital EBIT= Earnings before interest and tax V= Value
of firm

2. NET OPERATING INCOME (NOI) APPROACH Another theory of capital structure,

suggested but Durand, is the Net Operating Income approach. This approach is simply
opposite to the Net Income approach. The main findings are: Ø Capital structure
decisions are irrelevant to the valuation of the firm: According to Net Operating Income
approach, the capital structure decisions are irrelevant to the valuation of the firm.
Thus, if a firm makes any change in its capital structure, it will not affect the total value
of firm.

Ø Increased use of debt will increase the financial risk of the shareholders: The
increased use of debt in the capital structure would lead to an increase in the financial
risk of the equity shareholders. To compensate for the increased risk, the shareholders
would expect a higher rate of return and hence the cost of equity will increase. Thus
the advantage of use of debt is offset exactly by the increase in the cost of equity.

ASSUMPTIONS (a) The market capitalises the value of firm as a whole. (b) Cost of
debt (Kd) is constant. (c) Increases use of debt increases the financial risk of equity
shareholders which, in turn, raises the cost of equity (Ke). (d) Overall cost of capital
(Ko) remains constant for all levels of debt equity mix. (e) There is no corporate
income tax.

Various calculation under Net Operating Income approach are explained below: 1.
Value of Firm (V): V = EBIT Ko where, V = Value of firm EBIT= Earnings before
interest ant tax (Ko)= Overall cost of capital 2. Market Value of Equity (S): S =V–D
where, S= Market value of equity V= Value of firm D = Market value of debt.
3. Cost of Equity Capitalisation Rate: the increased use of debt in the capital structure
would lead to an increase in the financial risk of the equity shareholders. To
compensate for the increased risk, the shareholders would expect a higher rate of
return and hence the cost of equity will increase. Cost of Equity (Ke) or Equity
Capitalisation Rate = Earnings available for equity shareholders Market value of equity
(S) X 100.

3. THE TRADITIONAL APPROACH Traditional approach also known as intermediate

approach Is a mix of both the net income approach and the net operating income
approach. According to this approach, the prudent use of debt equity mix can lower
the firm’s overall cost of capital and thereby increase its market value. This approach
states that initially a firm can increase its value of reduce the overall cost of capital by
using more debt. However, the increase in the value of firm or reduction in the overall
cost of capital is possible only up to a particular level of debt equity mix. Beyond that
level, the value of firm start declining and the cost of capital start increasing. Thus, the
manner in which the value of firm and the cost of capital reacts to change in capital
structure can be divided into 3 stages as follow:

Stage 1: Increase in the value of firm and decrease in the cost of capital In the first
stage, both the cost of debt and cost of equity remain constant. As a result, the
increased use of debt in the capital structure will cause increase in the value of firm
and decrease in the overall cost of capital. This is based on the assumption that cost
of debt is less than cost of equity (i. e. Kd< Ke).
Stage 2: Optimal debt equity mix In the second stage, the firm reaches at an optimal
level. Optimal level means the ideal debt equity mix, which minimises the cost of
capital and maximises the value of the firm. Stage 3: Decrease in the value of firm and
increase in the cost of capital In the third stage the value of firm start declining and the
cost of capital start increasing. This happens because of debt beyond optimal level will
increase the risk of investors, so both Kd and Ke will rise sharply.

4. MODIGLIANI AND MILLER (MM) APPROACH Part I: If there are no corporate

taxes: Modigliani and Miller argue that in the absence of corporate taxes, the capital
value of the firm (V) and the overall cost of capital (Ko) is not affected but changes in
capital structure. In other words, debt equity mix is irrelevant in the determination of
the total value of the firm. The reason argued is that the increased use of debt in the
capital structure would lead to an increase in the financial risk of equity shareholders.
To compensate for the increased risk, the shareholders would expect a higher rate of
return and hence the cost of equity will increase. Thus the advantage of use of
cheaper source of finance (i. e. debt) is offset exactly by the increase in the cost of
equity.

Assumptions: MM approach is based upon the following assumptions: Ø There is a

perfect capital market. Ø Companies distributes all earnings to the shareholders. Ø
Business risk is same among all firms. Ø Investors are rational and choose a
combination of risk and return that is most beneficial to them
Part II: If there are corporate taxes: According to MM Approach, if there are corporate
taxes, the total value of the firm (V) and the overall cost of capital (Ko) will be affected
by changes in capital structure. According to this approach a firm can increase its total
value (V) and lower the overall cost of capital (Ko) by increasing the proportion of debt
in its capital structure.

Calculation of Value of Firm (V): When taxes are applicable to corporate income, the
value of firm is determined by the following formulas suggested by MM. Value of
Unlevered Firm (Vu) = EBIT(1 -t) Ke Value of Levered Firm (VL) = Vu + (D X T)
[where, D= Debt. t = Tax rate]

ESSENTIAL FEATURES OF A SOUND / OPTIMAL CAPITAL MIX Ø Maximum

possible use of leverage. Ø The capital structure should be flexible so that it can be
easily altered. Ø To avoid undue financial/business risk with the increase of debt. Ø
The use of debt should be within the capacity of a firm. The firm should be in a position
to meet its obligations in paying the loan and interest charges as and when due. Ø It
should involve minimum possible risk of loss of control. Ø It must avoid undue
restrictions in agreement of debt. Ø It should be easy to understand simple to operate
to the extent possible. Ø It should minimise the cost of financing and maximise
earnings per share.

FACTORS DETERMINING THE CAPITAL STRUCTURE 1. Financial Leverage or

Trading on Equity 10. Capital Market Conditions 2. Growth and Stability of Sales 11.
Assets Structure 3. Cost of Capital 12. Purpose of Financing 4. Risk 13. Period of
Finance 5. Cash Flow Ability to Service Debt 14. Costs of Floatation 6. Nature and
Size of a Firm 15. Personal Considerations 7. Control 16. Corporate Tax Rate 8.
Flexibility 17. Legal Requirements 9. Requirements of Investors

PRINCIPLES OF CAPITAL STRUCTURE DECISIONS Cost Principle Risk Principle

Control Principle Flexibility Principle Timing Principle

CAPITAL GEARING A company can raise finance by issuing three types of securities-
(i) Equity Shares, (ii) preference Shares, (iii) Debentures. Equity shares are
considered as variable return securities because the dividend on equity shares is not
fixed and may vary from year to year. On the other hand, preference shares and
debentures are considered as fixed return securities because the dividend/interest on
preferences shares/debentures is always fixed. The use of preference share capital
and debentures along with the equity share capital in the capital structure with a view
to increase earnings available to equity shareholders is known as “capital gearing” or
“trading on equity”. Thus, the term capital gearing refers to the proportion between
equity shareholders funds and fixed interest bearing securities.

Formula: Capital gearing = Equity Shareholders Funds (Equity Share Capital+

Reserves& Surplus) Preference Share Capital + Long Term Debt (Debentures).
Alternatively, Capital Gearing Ratio = Equity Shareholders Funds Total Capitalisation
(Eq. Share Capital + Pref. Share Capital + Debentures) X 100
SIGNIFICANCE OF CAPITAL GEARING Capital gearing has a direct impact on the
earnings available or equity shareholders. Hence the fixation of a proper ratio between
two or more types of securities is essential for maximising the earnings available for
equity shareholders. (1) Trading on equity: The use of fixed income bearing securities
along with equity with a view to increase earnings available to equity shareholders is
known as “trading on equity”. The benefits of trading on equity is enjoyed by the
company only if the rate of earnings of the company is higher than the fixed
interest/dividend charges. Thus, capital gearing helps in generating additional profits
for the equity shareholders at the expense of other forms of securities.

(2) Retention of Control: Equity shareholders are considered to be the real owners of
the company. They enjoy voting rights and participate in decision making process. If a
company needs funds for expansion it can exercise various options for raising finance.
However, if the existing shareholders do not want to dilute control over the company,
the company should prefer funds to be raised by issue of preference shares or
debentures. This is because the preference shareholders and debenturesholders are
not given any voting rights and as up o a certain level they also do not participate in
decision making process of the company.

(3) Trade Cycles: In order to improve profitability as well as financial position, the
companies usually follow the policy of low gearing during depression period and the
policy of high gearing during boom period.
CAPITAL GEARING AND TRADE CYCLES The effect of high and low gearing on the
financial position of a company during various phases of trade cycles are: (1) During
Boom Period: During boom period, the return on investments (ROI) of the company is
usually higher than the fixed rate of interest/dividend prevailing on
debentures/preference shares. Thus, during boom period, the company should follow
the policy of high gearing. This will improve the EPS as well as the financial position of
the company.

(2) During Depression Period: During depression period, the rate of earnings of the
company is usually lower than the fixed rate of interest/dividend prevailing on
debentures/preference shares. Hence, it becomes difficult for the company to pay
fixed costs of debentures and preference shares. Thus, during depression period, the
company should follow the policy of low gearing otherwise both the earnings per share
(EPS) as well as the financial position of the company will suffer adversely.

REASONS FOR CHANGES IN CAPITALISATION To Write –off the Deficit To Fund

Current Liabilities To Capitalise Retained Earnings To Suit Investors Needs To Fund
Accumulated Dividends To Simplify the Capital Structure To restore Balance In
Financial Plan To Clear Default on Fixed Cost Securities To Facilitate Merger and
Expansion REASONS To Meet Legal Requirements

Thank You !!!

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